Demonetisation update 10 – responding to Madhu Kishwar’s tweet

I hope Anantha Nageswaran’s optimism proves true. This piece is worth a read

I thank my good friend Madhu for tweeting my blog post but I think it would be a mistake to call my previous blog post (Demonetisation update 9) an optimistic one. It is neither. Indeed, right from the beginning and including in my joint MINT column with my co-author Gulzar Natarajan, I had said that there would be economic costs. This is the relevant paragraph:

Short-term economic disruptions are inevitable as households and the private sector have to learn to adjust to a new regime. Since India is also simultaneously moving to a goods and services tax (GST), the uncertainty could be compounded, resulting in some adverse economic impact in the short term. Most structural reform measures bring short-term dislocation with adverse consequences. This one would be no exception. That is why the government biting the bullet on this and sending a strong signal is a move in the right direction. This was a needed measure in many ways.

(5) Short-term liquidity squeeze could be severe and hence economic activity could suffer. Can last up to two or three quarters. If less, well and good. CLSA and Credit Suisse seem to think that (adverse) economic impact could be significant.

(6) Further, with the eventual design of the GST looking more complicated than originally envisaged and with the timelines getting shorter, uncertainty could be compounded. That risk is non-trivial. That is why GST should have been more concerned with simplicity, ease of use and implementation rather than revenue considerations. Bold thinking was always needed and more so, in the light of this announcement.

(7) In other words, a lot of learning is required of private sector participants to adapt to the new regimes – GST and de-monetisation. It will cause dislocation and uncertainty while learning happens and, two, it takes time.

(8) The government could have and should have (it still might) come up with additional economic stimulus too, to offset the dampening effect. Just thinking aloud here: (a) accelerated reduction in corporate income tax along with withdrawal of exemptions; (b) ending uncertainty on GAAR and retrospective taxation or any other blockbuster measure that they might be working on, that would offset the initial adverse economic impact.

(9) Whether this would boost eventually economic activity that is formal remains to be seen. But, orders of magnitude are very difficult to establish and hence, any claim of such improvement in formal economic activity with consequent beneficial tax impacts and other social economic multipliers must be deemed wholly speculative at this stage.

I stand by these observations.

Some people think that PM Modi has overplayed his hand, not factoring in the capability of the Indian state to implement such a massive shock. May be, he has. Or, may be, he has not. We will never know.

The nature of the exercise is such that it is impossible to get data and evidence to make reasonably accurate judgements. Therefore, in the short-run, the judgements reflect overweighting short-run evidence (which is overwhelmingly adverse) or personal biases or a combination of the two.

It is correct to ask questions but not to reach snap judgements. That is my point in my previous blog post.

In this respect, I completely echo Kenneth Rogoff although for the USA, I had disagreed with his suggestion especially in the context of zero interest rates. Removing US$100.00 bills would amount to a severe financial repression. Of course, he has clarified that he has called for gradual phaseout and that he wants a ‘less-cash’ society and not a ‘cashless’ society.

With respect to India, my blog post of last night is exactly captured by his words:

Will Modi’s plan work? Despite apparent huge holes in the planning (for example, the new notes India is printing are a different size and do not fit the ATM machines), many economists feel it could still have large positive effects in the long-run, shaking up the corruption, tax evasion, and crime that has long crippled the country. But the long-run gains depend on implementation, and it could take years to know how history will view this unprecedented move….

… What is happening in India is an extremely ambitious step in that direction, of a staggering scale that is immediately affecting 1.2 billion people. The short run costs are unfolding, but the long-run effects on India may well prove more than worth them, but it is very hard to know for sure at this stage. [Link – ht Prasanna Viswanathan of Swarajya]

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I think a lot of observers are mixing up shot term and long term economic variables. GDP is an activity measure and good for short term – and obviously, it takes a big hit with uncertainty. But wealth creation, a longer term concept is a compounding of multiple short term GDP reads in a sustainable manner. Demonetization and GST (hopefully), improves the sustainability of Indian growth story with a stable (transparent and accountable) economic structure. Hopefully no longer will we have a few years of flashes of 10% + (like 2007, 09-10, etc.) only to give up it to inflation or other uncertainty thereby impeding long term wealth creation (for short term GDP).

I think that would have to wait for a lot more things to happen. The economy remains stagflation prone, after few years of high growth. My co-author and I explore and examine these aspects in our book, ‘Can India Grow’